Chapter 21

Conclusion

Project financing differs, in important respects, from financing a project as an integral part of a firm's asset portfolio. Project financing may be an attractive strategy when (1) the project is large and capable of standing alone as an independent economic unit, (2) the sponsoring company (or companies) is sensitive to the use of its debt capacity to support the project, (3) the sponsoring company (or companies) is sensitive to its risk exposure to the project, and (4) the sponsoring company (or companies) wishes to maintain operating control of the project and is willing to accept the complex contractual arrangements, tight covenants, and close monitoring that project financing entails.

Reaping the Benefits of Project Financing

Under the right circumstances, project financing offers a number of advantages over directly financing a project on a conventional basis. The benefits that are available can be realized only after careful analysis and skillful financial engineering. The organization of the project, its legal structure, and its financing plan must reflect the nature of the project, identifiable project risks, the project's expected profitability, the creditworthiness of the various participants, the requirements for supplemental credit support to backstop the project's debt financing, the availability of project-related tax benefits, the financial positions of the project's sponsors, the needs of the host government, and any other factors that might affect the willingness of prospective lenders or equity investors to provide funds to the project. Project financing arrangements involve a community of interests among several parties. In the final analysis, the prospective economic rewards to each party must be commensurate with the risks each party will have to bear if the project moves forward. Only on that basis can each party's commitment to participate in the project be secured.

Project financing allocates returns and risks more efficiently than conventional financing. Project financing arrangements can be designed to allocate the project-related risks among the parties to the project who are in the best position to bear them (i.e., at lowest cost). Thus, engineering firms can bear the construction risk, raw material suppliers can bear the supply risk, the purchasers of the output can bear the product price risk, and so on.

Project financing can minimize the credit impact on the project sponsor(s). The contractual arrangements that support the project borrowings can be designed to minimize the direct financial commitments from the project's sponsor(s). (The direct financial commitments would be the sole source of credit support if the sponsor(s) financed the project internally.) As the rating agencies have become more sophisticated in their credit assessments, they have come to appreciate the manner in which project financing can draw on the credit support provided by other parties and thereby limit the credit exposure of the project's sponsor(s). The ability to have project debt rated has opened up the public bond market as a major source of funds, particularly for large projects.

As a result of the credit support provided by other parties, project financing facilitates greater leverage than the project sponsor(s) could prudently manage if the project was financed internally. Project leverage is often about double (at least initially) the leverage that is typical in corporate balance sheets. The higher leverage entails greater financial risk but it leads to greater returns if the project is successful. The higher leverage generates greater interest tax shields, which can enhance the project's value. Alternatively, limited partnership structures and/or leasing can be used to channel these tax benefits to other parties (in return for reduced financing costs).

Most recently, through the financing of hundreds of independent power projects, it has become evident that project financing is suitable for relatively low-risk projects that involve standardized nonproprietary technology. Financing such projects on a project basis can preserve a firm's internally generated cash flow to pursue projects that do involve a proprietary technology or are otherwise information-sensitive. Thus, informational asymmetry costs associated with other growth opportunities available to a firm can enhance the usefulness of project financing. Firms with attractive growth opportunities in areas where proprietary information is being kept secret from competitors will find project financing particularly attractive for their more routine activities, such as electric power cogeneration. Projects based on a proprietary technology are more likely than other projects to lead to supernormal rates of return. Thus, its choice of project financing for routine projects should send a positive signal to the capital market that a firm has valuable growth opportunities.

Project financing involves two other potential benefits. First, it can be used to avoid, or at least minimize, the impact of existing covenant restrictions in the sponsors' current debt agreements. However, the project borrowing arrangements will contain their own set of covenant restrictions. Second, project financing can achieve off-balance-sheet treatment of project debt. However, the accounting profession's expansion of disclosure requirements in recent years is making this particular benefit less and less tangible.

Project financing involves higher transaction costs than conventional financing. Principally, the higher costs are associated with tailoring the project financing arrangements. Monitoring costs are also significantly higher. Consequently, project financing tends to involve comparatively large projects; their size permits them to generate sufficient benefits to offset the necessary expenditures and higher transaction costs.

Despite the higher transaction costs, project financing can reduce the overall after-tax risk-adjusted cost of capital in the right circumstances. As a result, project financing has attracted growing interest as a means of obtaining capital for large projects that can stand alone as independent economic units. Its potential is perhaps greatest for the many large infrastructure capital investment projects that are on the drawing boards in both the less developed and more developed countries. The projects are large and expensive, and the risks are great. But the potential benefits are enormous. Project financing could be the answer.

Recognizing When Project Financing Can Be Beneficial

Given the complex decisions that have to be made in planning the financing of a major project, it is essential that the project sponsor(s) develop a thorough understanding of the proposed project—its risks, estimated investment requirements, and projected returns.

Most importantly, the project sponsor(s) need to determine at the outset whether project financing is the most cost-effective method of financing the project. Real-options analysis can be very helpful in identifying and valuing hidden options so as to calculate the total NPV of a project correctly.

Project financing has long been used to finance large natural resource projects involving several parties, such as the Trans Alaska Pipeline System (TAPS) Project, a joint venture among ten of the world's largest oil companies. A more recent North American joint venture, Hibernia Oil Field Partners, was recently successful in developing and bringing into full-scale production a major oil field off the coast of Newfoundland.

A large project financing can, by facilitating a large-scale capital project, bring significant public benefits. For example, the Hibernia Oil Field Project has created jobs and provided economic stimulus to a severely depressed region. Its public benefits began years before the first drop of oil flowed. Furthermore, it created an environment suitable for development of other nearby oil fields. Because of these social benefits, both the Canadian Federal Government and the Newfoundland Provincial Government became major players as the project moved forward. I expect that project financing will continue to be a pivotal factor, as in the TAPS Project and the Hibernia Oil Field Project, in the development of the world's natural resources. The large percentage of oil and gas projects in the past 10 years documented in Chapter 3 bears this out.

Project financing can facilitate the development of large infrastructure projects, which are often critical to a country's economic growth. Despite these potential benefits, a project financing might negatively affect the host country by wasting natural resources, degrading the local environment, or displacing local communities unless project sponsors act responsibly to avoid these negative externalities. Host countries cannot solve this problem by themselves. The international project lending community has endorsed standards to prevent, or at least minimize, potential adverse effects. By adopting the IFC Performance Standards and the Equator Principles, large international project lenders have endorsed the importance of considering the potential environmental and social impact, not just the economic feasibility, of international projects before they agree to lend.

Potential Future Applications of Project Financing

The number of opportunities to reap the benefits of project financing is likely to increase. Power projects continue to be prime candidates for project financing. The technique has worked well, and the financing structures are well established. Project financing would also seem to be well suited for financing flexible regional industrial facilities that can make a variety of goods for the local market. Facilities that can achieve significant economies of scale, but only if they can serve the needs of multiple sponsors and achieve a scale that permits these economies to be realized, could be project financed. Independent project ownership enables entering into arm's-length agreements with multiple firms so that a plant can operate at a profitable level of output and not have to depend on any single firm's success.

Infrastructure projects are, potentially, an even more fruitful area for project financing. Rebuilding the infrastructure in the more developed parts of the world, and building an adequate initial system of infrastructure in the less developed parts of the world, will require hundreds of billions of dollars. Infrastructure has typically been the responsibility of the public sector. But, even in the United States, it has been well documented that public spending on infrastructure has fallen far short of what is needed to meet the country's infrastructure requirements. Some financial economists have proposed developing public–private partnerships to raise the funds needed to build, own, and operate these projects. Recent efforts to structure project financings on this basis have been successful. But, in view of the magnitude of the funds needed and the complex risk-return structures, these projects pose a daunting challenge for both public officials and private financiers.

Islamic finance has grown significantly within the past decade. It has become a major component of the global financial system. The Islamic finance capital market globally is probably in excess of $1 trillion equivalent. Islamic finance is well suited to project financing because it is structured around physical assets. There are challenges in designing a financing structure both to comply with Sharia principles and to fit the risk-return characteristics of the project, which require creative legal and financial engineering. Islamic countries have a very substantial need for infrastructure investment to support their rapid economic growth. Project financing opportunities abound, and I expect that Islamic project finance will play an increasingly important role in furthering the economic development of these countries.

Organizational (Re)Form

Project financing involves the choice of an alternative organizational form. It differs significantly from the indefinite-life corporate form. The typical corporation has a portfolio of assets whose returns are not perfectly correlated; its managers enjoy wide discretion over the allocation of free cash flow; and it tends to perpetuate itself by reinvesting free cash flow in new assets and new businesses. A project financing is tied to a specific asset or pool of assets. It can be organized as a corporation, as a partnership, or as a limited liability company. The project entity's life is finite because it is tied to a finite-life project. Free cash flow is distributed to the equity investors rather than reinvested at the discretion of management.

Some financial economists have even argued that project financing has the potential to alter fundamentally the structure of corporate governance. Finite-life organizational forms would be linked to specific facilities. They would pay out their free cash flow to their equity investors. Equity investors, rather than managers, would control the reinvestment of free cash flows generated by these finite-life enterprises. Finite-life organizations are perfectly appropriate for certain types of activities. Project financing, as described in this book, is a useful special form of financing, not a revolution in corporate organization and governance.

Financial Engineering

Project financing can best be thought of as a form of asset-based financial engineering. It is asset-based because each financing is tailored around a specific asset or a pool of related assets. It involves financial engineering because, in so many cases, the financing structure cannot simply be copied from some other project. Rather, it must be crafted specifically for the project at hand.

Financial engineering also plays an important role in project risk management. Interest rate, currency, and credit default swaps are new risk management tools that project sponsors can use to eliminate the project's exposure to certain risks selectively. These useful risk management tools, coupled with more traditional forwards, futures, and options, can be critical in arranging project financing because the allocation of risk bearing is a vitally important step in project structuring and financing.

Islamic finance is developing rapidly as financial engineers work with Sharia scholars to craft new financial instruments and new transaction structures that comply with Sharia. With Muslim populations and economies growing rapidly, Sharia-compliant project financing will play an increasingly important role in global infrastructure development. The large pools of wealth in these countries will also be available to finance projects in Western countries. But this will happen only if financing structures can be developed that satisfy both conventional Western lending standards and the strictures of Islamic law. The structures discussed in this book are but a starting point. I expect that Islamic financial instruments will continue to evolve and that the markets for them will continue to expand to take advantage of the abundant opportunities for Islamic project financing.

This book has noted the many advantages (as well as disadvantages) of project financing. It has described the circumstances in which project financing might be beneficial to a firm's shareholders, and has emphasized that a project financing must be designed to serve a community of interests among several parties to a project. Consequently, no single rationale can completely explain why firms employ project financing. Clever corporate financial engineers will continue to find new applications of project financing. As the financial environment continues to evolve, project financing will continue to enjoy a prominent place among the most important financing techniques in the global economy.